Long-Term Quality Investments Hit Optimal Zone
Theoretically, all investment actions can be classified into positive, neutral, and negative contributions. If you are unsure which actions count as positive, it might be best to refrain from any actions at all, as neutral is certainly better than negative. So, what constitutes a negative action? For instance, constantly watching the market to learn technical analysis or seeking insider information are certainly bad habits in investing. Although these habits may yield some short-term gains, over time they can only be detrimental to one’s investment journey.
In a bull market, if there is one action that is guaranteed to lead to significant losses, it is investing in junk stocks. Peter Lynch once stated that buying junk stocks in a bull market is the greatest risk for retail investors. This action combines the dual risks of overvaluation and low quality. When comparing these two risks, it is evident that low-quality junk stocks carry a greater risk. Overpaying might only mean losing time in the long run, but investing in a junk company results in a permanent loss.
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Munger advises looking at problems from the opposite perspective. What lies on the opposite side of the negative checklist is likely to be the correct action. Regardless of whether the market is bullish or bearish, investing in high-quality assets is the source of long-term investment returns.
Dissecting Buffett: Quality is the Core of Excess Returns
To understand the source of long-term returns, the best approach is to examine the investment career of Warren Buffett, who has been active in the market longer than anyone else.
Firstly, just how exceptional is Buffett? We selected Berkshire Hathaway's performance from October 1976 to March 2017, spanning over 40 years. During this period, Buffett's Sharpe Ratio reached an impressive 0.79, which is 1.6 times the market average. Buffett's returns outperformed those of all stocks, ranking in the top 7%.
Secondly, what is the core of Buffett's excess returns? From January 1977 to May 2016, Berkshire's stock averaged a return of 17.60%, of which 6.80% came from market beta returns, with Buffett's main excess return stemming from the quality factor, contributing an annualized 3.4% return, making it the largest component among all the style factors Buffett was exposed to (Source: Factsets; Data Range: January 1, 1997 – May 31, 2016).
Finally, why are high-quality companies the primary source of returns in value investing? When we look at the essence of investment returns, the distribution of returns in the equity market is not uniform, with a small number of high-quality companies providing the bulk of investor returns. For instance, in the century-long history of the U.S. stock market, the top 4% of companies accounted for all the returns, while most mediocre companies did not generate any value return.
Our A-share market exhibits this characteristic as well; for example, long-term returns of the CSI 300 index closely align with the ROE of its constituent stocks. The quality of underlying assets determines the long-term return of this market.
The Iteration of Quality Investment by Miao Yu
Quality investment is the fruit of time; the longer the time, the more significant the excess returns. In the A-share market, there are also a number of excellent quality-oriented fund managers. They are typically seasoned investors with years of experience, who only come to appreciate the slow pace of compound interest after a long period of honing their craft.
Each year, we publish a Top 100 fund managers list, which includes those we consider to be outstanding quality-oriented fund managers. Miao Yu from Dongfanghong Asset Management has been included in our list for three consecutive years. As early as 2022, we incorporated Miao Yu, who was still at GF Fund, into our Top 100 fund managers list, maintaining this inclusion since then.
Even in the past few years, despite the lackluster performance of high-quality factors, Miao Yu has remained committed to investing in companies of high quality. With 16 years of industry experience and 9 years of fund management experience, Miao Yu has established a solid foundational investment framework that will not waver due to environmental changes.
In Miao Yu's investment career, there are two critical junctures.
The first was from the second half of 2015 to the first half of 2016. In February 2015, after many years as a fund manager assistant, Miao Yu officially transitioned to an investment role. At that time, he encountered the “Internet Plus” wave, actively participating in the market and significantly increasing the net value of the funds he managed.
However, the market began to undergo continuous adjustments in the second half of 2015, resulting in significant drawdown in the portfolios managed by Miao Yu. Subsequently, he began reevaluating his investment framework.
Starting in 2016, Miao Yu gradually shifted from investing based on industrial trends to focusing on value investment in high-quality growth leaders. This experience was pivotal and marked his first real establishment of an investment framework suited to himself. After 2016, Miao Yu concentrated on high-quality growth stocks.
The second key juncture was from the second half of 2020 to the first half of 2021. By focusing on high-quality investments, Miao Yu began to expand his portfolio from the previous realm of consumer goods to large-scale manufacturing sectors such as new energy vehicles, photovoltaics, automotive, and electronics. It was also from that year that Miao Yu added 4 new words—“continuous iteration”—to his previously held twelve-character investment philosophy of “long-termism, valuation protection, and moderate diversification.”
Stepping outside one's circle of competence means more than just gaining a broader understanding of an industry. To excel in long-term investing, one must understand iteration. Iteration is entirely different from style drift; it involves evolving on the foundation of an existing investment framework since markets undergo significant changes periodically.
Pricing Using a Full Lifecycle Model
Miao Yu, who graduated with a PhD in Science from Fudan University, was quickly recognized by the leadership of the research department upon entering the industry, being allocated the most high-growth steel and non-ferrous metals stocks at that time. However, he soon realized these growth stocks had become cyclical stocks, which remained sluggish during the economic transformation phase for several years.
This experience also allowed Miao Yu to establish a cyclical pricing mindset early on. All growth stocks will eventually transition into cyclical stocks. Even today, many tech stocks may also evolve into cyclical stocks; it's just that the stages of development differ.
Among quality-style fund managers, Miao Yu belongs to the few who possess a cyclical mindset. He tracks the industry cycles of the companies he invests in, understands the developmental patterns behind those cycles, and applies differentiated pricing to companies in different cycles. The pricing models for introduction, development, and maturity stages are entirely different. Emerging industries in their introduction phase typically receive a higher valuation and expectations. After reaching the maturity phase, the competitive landscape stabilizes while maintaining a relatively stable valuation. Miao Yu believes that from a secondary market investment perspective, investing in companies during the introduction phase and the maturity phase constitutes a sound approach, with the core focus being on assessing the position within the industrial cycle.
One book that Miao Yu highly recommends is “Capital Cycles” by Marathon Capital. This book provides a detailed discussion on the investment framework for supply-side cycles across different industries. While studying the demand cycle, one must not overlook the capital cycle on the supply side, which is becoming increasingly significant in today's growth environment.
Just as everyone goes through youth, maturity, and aging, every enterprise also has its own lifecycle. The distinction is that some enterprises can find a second curve of growth after aging, achieving a “rebirth.” Different business models yield varying growth phases for enterprises. Some can maintain their youth for 30 years, while others may begin to age rapidly within just 3 years.
At the end of 2018, Miao Yu invested in a traditional tea company undergoing a “rebirth.” During his review of announcements, he stumbled upon an equity incentive plan initiated by the management, indicating their optimism for the company's future growth. Through further research, Miao Yu discovered that the company had recently launched a new fruit tea product, thereby establishing its second growth curve.
When conducting product tracking research, Miao Yu found that this product was selling exceptionally well across various channels. After discovering the second growth curve, the company’s operating cycle returned to rapid growth.
By mid-2019, through grassroots research in the channels, Miao Yu discovered that the peak for channel distribution had passed based on product sales data. As the sales cycle for new products entered a downturn, and combining this with the company's high valuation at that time, Miao Yu chose to take profits.
The full lifecycle pricing mindset has made Miao Yu’s investments distinctly different in two ways:
1) A broader circle of competence, enabling him to price not just a single type of asset. In contrast, traditional quality-style fund managers predominantly invest in mature companies;
2) Continuous iteration of the investment framework. Every industry has its lifecycle, and clinging to one’s circle of competence cannot be viewed as a form of “carving a boat to seek a sword.” If one only excels in investing in a single industry, then during its decline, they will struggle to find investable targets.
From Miao Yu's investment portfolio, we can also observe his iterative evolution. He initially focused on consumer goods but gradually expanded into large-scale manufacturing and technological innovation, similar to Buffett's journey from early investment in consumer products to technology stocks later on. Today, Apple stands as Buffett's most profitable stock. Only through continuously iterated high-quality investments can one keep pace with the progress of the times.
Continuously Exploring the Unknown World
Buffett has once said that the typical characteristics of value investors include in-depth research, long-term investing, and concentrated investments. Historically, Buffett's top three holdings have accounted for over 50% of his portfolio, with many stocks held for over a decade.
From Miao Yu, we see these traits of value investors as well. Observing Miao Yu’s historical investing style reveals a notably low turnover rate and a high concentration in his top ten holdings. In investing, it is only after establishing a deep research understanding that he takes action, often investing heavily.
For instance, in the A-share market, two leading high-end liquor companies have been heavily held by Miao Yu since 2017, long remaining in the top ten stocks of his portfolio. After transitioning from GF Fund to Dongfanghong Asset Management, Miao Yu also promptly included these two companies among his top ten holdings.
Moreover, Miao Yu's investments in high-quality companies are not limited exclusively to the consumer goods sector. He was among the early fund managers to pay attention to electric vehicles but refrained from making purchases until he established a depth of research. Once he clarified the industrial chain and competitive advantages of electric vehicles, he began to heavily invest in a leading battery company.
Anyone who has communicated with Miao Yu can sense his open mindset. As a value investor, he does not reject many new concepts. He firmly believes that a person with an open mind can excel in investing. While he may choose not to invest, he sees the value in understanding.
In a discussion held a year ago, Miao Yu likened the expansion of one's capability circle to "StarCraft." In this game, unexplored maps are invisible; players must establish a main base while sending farmers out to explore the unknown world. There, they may sometimes discover new sub-mines, bringing additional economic resources, and at other times encounter opponents. However, only through continual exploration can success be achieved in such a game.
Miao Yu has been exploring in the unknown world, gradually expanding his circle of competence to adapt to the ever-changing A-share market.
Combining Long-Term and Consistency
During interviews with fund managers, we consider one of the most important questions to be regarding the fund managers' investment values. All investment frameworks are formed based on values, which tend to be more stable than the frameworks themselves. The foundation of these values often relates to an individual's experiences, beliefs, and various other factors.
The first aspect of Miao Yu's investment philosophy is captured in the term "long-termism." Achieving long-term success in any endeavor is challenging, requiring a combination of subjective will and objective external conditions. We find that Miao Yu's long-termism manifests on three levels:
The first level is the long-term effectiveness of the investment method. This is the most crucial part of long-termism. Only by consistently engaging in effective actions can one achieve compound growth over time. Conversely, persisting in ineffective actions not only fails to yield compounding benefits but also distances one further from the correct path.
We mentioned earlier that investing in high-quality companies is one of the most effective long-term strategies. Across any country's stock market, high-quality companies generate the majority of return rates. By integrating quality and value, one can further optimize yields.
The second level is the long-term operability of the investment method. We conducted research that revealed a significant negative correlation between fund managers' turnover rates and their ages. As fund managers age, their turnover rates tend to decrease. This suggests that methods involving high turnover rates may not be sustainable for fund managers.
Moreover, we also observe that fund managers possess their own lifecycle, where factors such as one's physical strength, family situation, and motivational drivers change with age. These changes subtly influence a fund manager's investment operations over their lifetime.
After one year of investing, Miao Yu shifted his focus from early-stage industry trend investments to more long-term actionable investments. We also found that as he aged and evolved, Miao Yu’s investment behavior did not change.
The third level is that this investment methodology must align with one’s inherent character and values. Miao Yu enjoys extensive reading, and through this, he discovers that the competitive positioning of different companies is intimately connected to the values of their management teams. He approaches stocks from the perspective of a business rather than merely viewing them as “chips.” Regular reading reinforces a positive feedback mechanism for Miao Yu, enabling him to adopt a shareholder’s perspective on issues.
High-Quality Assets May Revert to the Mean
In recent years, the performance of the high-quality factor in the A-share market has been underwhelming. Since the Chinese New Year in 2021, blue-chip growth stocks have faced ongoing adjustments. Interestingly, similar instances in U.S. history also saw the high-quality factor lagging the market for three consecutive years. Between 1997 and 1999, high-quality companies underperformed the S&P 500 by over 40%!
In 1998 alone, high-quality companies underperformed the S&P 500 by over 27%. The following year, 1999, saw Buffett suffer his most significant underperformance in the market.
However, after that period, high-quality companies experienced an upward mean reversion, outperforming the S&P 500 each year from 2000 to 2002, with cumulative excess returns approaching 83%. Not only did they recover from previous underperformance, but they also continued to outperform the market throughout that entire period.
Such a mean reversion could potentially occur in the current A-share market as well. Following the rebound that began in mid-September, the premium valuations of quality blue-chip stocks have not surpassed those of lower-quality companies. From a cost-performance perspective, this group of high-quality companies not only exhibits superior fundamentals but also does not show any premium in valuation.
Starting from October 21, the Orient Red Power Leadership Mixed Securities Investment Fund (Class A 021647, Class C 021648) has officially launched, marking the first new fund managed by Miao Yu after joining Dongfanghong Asset Management.
Miao Yu, who has long focused on high-quality growth stocks, may very well be entering his most favorable batting zone.
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